We Think Wharf (Holdings) (HKG:4) Can Stay On Top Of Its Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Wharf (Holdings) Limited (HKG:4) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Wharf (Holdings)

What Is Wharf (Holdings)'s Debt?

The image below, which you can click on for greater detail, shows that at June 2021 Wharf (Holdings) had debt of HK$61.6b, up from HK$42.2b in one year. On the flip side, it has HK$20.0b in cash leading to net debt of about HK$41.6b.

How Strong Is Wharf (Holdings)'s Balance Sheet?

We can see from the most recent balance sheet that Wharf (Holdings) had liabilities of HK$51.2b falling due within a year, and liabilities of HK$57.3b due beyond that. Offsetting these obligations, it had cash of HK$20.0b as well as receivables valued at HK$2.70b due within 12 months. So it has liabilities totalling HK$85.8b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's huge HK$79.8b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Wharf (Holdings)'s net debt is 3.1 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 35.8 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. It is well worth noting that Wharf (Holdings)'s EBIT shot up like bamboo after rain, gaining 93% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Wharf (Holdings)'s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Wharf (Holdings) recorded free cash flow worth 70% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Both Wharf (Holdings)'s ability to to cover its interest expense with its EBIT and its EBIT growth rate gave us comfort that it can handle its debt. On the other hand, its level of total liabilities makes us a little less comfortable about its debt. When we consider all the elements mentioned above, it seems to us that Wharf (Holdings) is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Wharf (Holdings) insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.